Tuesday, 22 October 2013

Good value? Where's the data behind "the most transparent deal ever made"?

Here's a thing - I'm actually quite good at modelling costs.

So when the Energy Secretary yesterday announced an effective tax on electricity bills to support the building of a £16bn nuclear power station at Hinkley Point I naturally started to pick apart the details of the deal.

But I came unstuck. Whilst Ed Davey trumpeted the investment in nuclear power as good value for British energy consumers and "the most transparent deal ever made", I struggled to find any substantial data to explain the inflation-linked "Strike Price", a consumer-subsidised rate of £92.50 per megawatt hour that the private consortium building the plant will receive for electricity until 2058.

Yes, the government's website is flush with press releases and infographics trumpeting job creation and low-carbon energy production, but what I really want is the business plan that justifies the public subsidy.

Given such information I will be able to give a better view on whether the deal really does represent a good deal for the taxpayer.

After all, capital costs of £16bn seem rather high, even for a nuclear power station. And given the nature of the deal - what amounts to a Wonga-funded hire purchase with investors expecting a 10% annual return on their investment (FT subscription required), it's all a bit incestuous; the supplier also gains through the provision of finance, tempering the market forces that should otherwise be driving down construction costs.

The government seems to be taking all the risks: fixing prices, providing guarantees against cost overruns; why its even committed to underwriting 65% of the capital costs as public debt - are the investors hoping to make a 10% return on the government's own money, too?!

With no solid data in the public domain its impossible to judge whether we're being sold up the river.

And here's a thing. Building a model with the data that is available (an inflation estimate of 2%, a strike price of £92.50, construction costs of £16bn and a best-estimate of operating costs of 2.8p per kWh - adjusting the 2009 UK fleet average data for inflation) the investors won't be getting the equivalent of a 10% average annual return. It will be more like 9%, after adjusting for the absence of dividends over the construction period.

However should inflation average 2.5% they will see a return of around 9.5%

But as I mentioned I can't find details behind the government debt underwriting 65% of the initial outlay. If investors are only providing 35% of the funds then either the government stands to make a hidden return on underwriting the deal (UK 30-year gilts currently yield around 3.6% - far less than the 9% return my model indicates), or the private consortium stands to make a far higher return on their 35% contribution than they have so far admitted.

Of course my calculations all hinge on inflation-linked best-guess operating costs of 2.8p per kWh. This includes everything from fuel and staff costs to waste processing and storage and setting-aside the required decommissioning costs under a Funded Decommissioning Programme.

It's not inconceivable that EDF believes it can run the plant more cheaply than the average for the UK fleet. After all this will be a modern high-output plant with associated economies of scale. Some US studies claim operating costs as low as around one cent per kWh.

If EDF can get the operating costs down to around 1.8p/kWh they should easily make a return of 10% on the £16bn capital outlay, even if inflation hovers around 2%.

But here's the kicker. If the government actually funded the whole project with public borrowing, assuming it was capable of delivering on time and on budget, the cost of borrowing would fall to around 3.6% - the price the government pays on its long-term debt.

Now with debt at this price and inflation-linked operating costs of 2.8p per kWh the strike price could be as low as £54.00 per megawatt hour - not far off the current wholesale price of electricity.

Additionally if operating costs of a modern plant can fall to around 1.8p/kWh the plant could be undercutting current power generators with a unit price of £48.50 per megawatt hour once capital costs are included. Bearing in mind capital costs and interest in this model are amortised over the first 35 years of the plant's planned 60-year life, costs should fall substantially in the second half of its life.

So has the government got it wrong? In its eagerness to involve private finance it has been forced to rig the market, sacrificing one free market ideal for another.

This market rigging tempers incentives to innovate to reduce construction and operating costs whilst providing a bad deal for customers; driving-up the overall cost of electricity and skewing the wholesale market for all generators. Britain will be paying twice as much for electricity in real terms by 2050.

Whilst it seems to go against the ideology of a right wing government, a better option may well have been to leave the price to the market and fund the construction as a government project.

PPS assumptions in my model: the power station capacity is 3,200 megawatt, reactors are likely to be offline for around 40 days every 18 months for refuelling, electricity will be sold at £92.50 per megawatt hour and government sources are talking a lot about CPI inflation of 2% in relation to this deal, so we can assume that might be the figure EDF used in its own economic modelling. We also know investors expect a return of around 10% and the initial outlay is £16bn.

1 comment:

Is this another uranium light water plant? Good god the cold war is 40 years concluded, what the hell are we doing as a civilisation? Mine and probably my childrens lifetimes wasted waiting for the true emancipatory nuclear energy revolution, hundreds of years after the discovery of fission!

As for the substance of the article.......british taxpayer gets taken for a spin while private investors make out like bandits? Holy See confirms popes subscription to catholicism in a statement released last night by vatican officials?